When should a business file as an S-corp
An S-corp is not a formal business structure, it is a tax classification. But under what conditions can a business elect the S-corp tax classification?
LLCs can be taxed in one of two ways, they can either choose to be taxed as a default LLC, or they can elect to be taxed as an S-corp. If we think about an LLC vs an S-corp, both tax designations have their own pros and cons, but it is important to know when a business qualifies to elect the S-corp designation, and when it will lead to concrete benefits.
The difference between an LLC and an S-corp
An S-corp is one of the Internal Revenue Service’s (IRS) tax designations that LLCs and corporations can choose. Unlike an LLC, an S-corp is not a formal business structure. The difference between an LLC and an S-corp is in how they are taxed. LLCs that are taxed as default LLCs pay FICA (Medicare and Social Security Tax) and income tax on all profits and distributions while LLCs taxed as S-corp pay FICA and income tax on their salary but only pay income tax on distributions. Most LLCs tend to be taxed as a default LLC because they don’t carry over a high enough profit to meet the requirements to qualify to elect the S-corp designation or to make it beneficial. But what are the benefits? The S-corp classification allows business owners to be taxed as employees of their LLC, meaning they only pay FICA and income tax on their salary and can save about 17% on the distribution portion of their income because the distribution portion is only subject to income tax.
When to use the S-corp tax designation
An LLC can also elect to be taxed as an S-corp provided that certain conditions, identified by the IRS, are met. It only makes sense for an LLC to use the S-corp designation if the business can pay owners a “reasonable” salary, if the business has substantial distributions carried over year after year, if there is a positive return on investments for payroll service costs, in other words, if the financial tax advantage offsets the cost of maintaining the S-corp, and only if an LLC meets the IRS S-corp requirements may it request to be taxed as an S-corp.
Yet many LLCs and small businesses do not meet these S-corp criteria, these businesses benefit more from the default LLC tax classification. Because LLC owners often put as much profit back into the business year after year to promote growth, they do not have substantial profits and distributions to qualify to be taxed as an S-corp. The default LLC tax classification is thus best suited for businesses where owners reinvest their profits and if the cost of bookkeeping and payroll services outweigh the tax benefit of an S-corp. It therefore only makes sense for LLC to elect the S-corp classification if enough profits are carried over from one tax year to the next to pay owners a reasonable salary and substantial distributions. Usually, businesses with an annual distribution of more than $10,000, after paying the owner a reasonable salary, have enough profits to justify electing the S-corp designation. LLCs owners can elect to be taxed as an S-corp on the IRS website by filing out Form 2553.
If you are unsure about the amount of profit your business will generator, or if you would like to invest as much profit as possible back into your business, it’s always best to hold off on electing the S-corp tax classification, you can always apply to be taxed at a later date when it better suits the business. If you want to learn more about when your business qualifies for the S-corp designation and the benefits of doing so, visit TRUiC’s website to find out which tax designation is best for your business..